Analysis: Delta's refinery bid looks better on second glance

NEW YORK Delta Air Lines' (DAL.N) expected bid to buy a Pennsylvania oil refinery has had people in both industries joking that a company from the money-losing airline sector would be right at home in the money-losing world of East Coast refining.

But with the deal to buy ConocoPhillips' (COP.N) Trainer, Pennsylvania, refinery expected to be confirmed imminently, some say that Delta, the country's No. 2 carrier, could have the last laugh.

Airlines, after all, know a thing or two about managing high-risk, logistics-intensive industries through a slump. While Delta would be the first airline to buy into the sector, other end-users from Midwest farmers to steel companies have invested in the past; more recently, private equity firms have moved in.

Others say the deal is a defensive one, necessary to help prevent a run-up in fuel costs: the only other bidders for the plant wanted to shut it down and run it as a terminal, a move that could have reduced East Coast jet fuel supplies by more than a fifth and forced Delta to pay more for imports.

And while news of the bid surfaced only a month ago, it doesn't seem to be a hasty decision. Delta sent a team of experienced refinery specialists to examine the plant, which has refining capacity of 185,000 barrels a day, as early as last November, several sources familiar with the deal told Reuters. It established its bidding vehicle Monroe Energy LLC on December 13, 2011, according to Delaware records.

"It is an opportunity risk that Delta faces versus a negative risk exposure," says Geary Sikich, principal of Indiana-based Logical Management Systems, which specializes in assessing business risk and which has helped produce risk-modeling plans for major U.S. refiners.

JP Morgan's (JPM.N) involvement in the bid as financier and designated oil trader also raised some eyebrows, yet to many makes good sense. Not only has the bank become the biggest energy derivatives trader on Wall Street, but the refinery's proximity to New York Harbor - the pricing point for gasoline and heating oil futures - makes it especially enticing.

Several sources who have participated in the discussions expect the deal to be announced early next week, around the time of the May 1 spin-off of ConocoPhillips' refining arm into a separate company called Phillips 66.

Under the expected terms, Delta would purchase the refinery for around $150 million - about the cost of a new wide-body jet - and JP Morgan's commodities team would finance the refining process, including buying crude and selling fuel.

Both company have declined to comment on the discussions.

INDUSTRIES IN CRISIS

To be sure, it is a risky bet brought on by dueling crises in both industries.

Rising fuel prices pushed major U.S. airlines into the red for the first quarter of 2012 and could continue to put pressure on results during the peak travel season.

East Coast refining has also been pushed to the brink of insolvency, with a quarter of the region's initial 1.6 million barrels per day (bpd) of capacity already shut down, according to U.S. government data. Trainer, which has been idle since last year, is one of three refineries in the Philadelphia area that will be permanently shut if buyers aren't found.

Margins have been slammed by the converging pressures of high-cost imported crude oil feedstock, dwindling local fuel demand and heavy competition from new, modern plants in India, and Midwest rivals gorging on a surge in Canadian and North Dakota inland oil, trading at unprecedented discounts.

Simply owning a refinery would not protect Delta from rising crude oil prices. A penny saved buying at-cost jet fuel from the refinery would be one penny less Delta would earn at the plant, which would be paying market prices for its feedstock.

But there is a strategic dimension.

In 2010, more than 61,000 Delta flights departed from the three major New York-area airports, more than any carrier apart from Continental, according to government data. The hub accounts for 7 percent of Delta's U.S.-based flights. And Delta has just expanded service from LaGuardia and is spending $1.2 billion on a major overhaul of its facilities at JFK.

Shutting Trainer could jeopardize supply from a plant that is configured to produce about twice as much jet fuel as the average East Coast plant, according to U.S. Energy Information Administration data. It has the capacity to produce some 23,000 bpd of jet kerosene, more than 20 percent of the region's total.

Plus, keeping the plant running would give Delta more control over its own supply chain and, more importantly, could stave off the cost of importing fuel by tanker from Europe or the Gulf.

It now costs about 6 cents a gallon to ship clean fuel from Europe to Philadelphia. That could potentially add another 2 percent to Delta's fuel bill, which totaled more than $12 billion last year, when it consumed some 3.86 billion gallons or just over 250,000 barrels per day of jet fuel globally.

Last year, Delta paid an average of $3.06 a gallon, up nearly a third from 2010. For 2012, the U.S. Department of Energy forecasts the cost of jet fuel to average $3.35 a gallon.

Key to the venture's success would be tempering feedstock costs. In 2010, the last year in which Trainer was fully operating, it imported 175,000 barrels per day of crude, 75 percent of which was costly sweet crude from African producers including Nigeria, Angola and Algeria. Only 20 percent was relatively cheaper crude from Canada.

The new owners intend to change that by hauling some of the cut-price crude from North Dakota overland by train to Albany, New York, where it will be trucked or barged down to the Philadelphia region, according to sources involved in the talks. There are no pipelines to carry the crude directly.

"This will be a key part of the East Coast refining industry going forward. Finding a way to take the growing midcontinent crude and move it to the East Coast makes it a midstream solution," said one industry source with knowledge of the deal.

Light, sweet Bakken crude has recently has been trading at least a $20 discount to Brent crude, the benchmark for almost all oil produced in Europe and West Africa.

Apart from the obvious risks associated with operating a vast, volatile industrial facility, the danger now is that other East Coast plants may also be pulled back from the brink, plunging profit margins into the red.

"This is a jet gamble versus a gasoline gamble," said a source familiar with the deal.

STRANGE BEDFELLOWS

Delta would not be the first non-energy company to take fuel supplies into its own hands.

The Coffeyville Resources refinery in Kansas was built decades ago by a farmer group wanting to produce its own diesel, a mainstay fuel for planting and harvesting in the nation's breadbasket. CHS, now the nation's biggest farm collective, has owned refineries in Montana and Kansas since 1943.

Industrial firms also invested. Chemicals giant DuPont (DD.N) bought Conoco itself in early 1981 to provide a secure source of petroleum feedstocks. U.S. Steel bought refiner Marathon the following year, angling both to diversify its business and get a better grip on energy costs. Both companies split out their energy divisions two decades later.

The mechanics of refining would be foreign to a consumer-oriented corporation like Delta, but elements of the industry may be familiar, says Robert Mann, an airline consultant in Port Washington, New York.

"It's an environmental nightmare, potentially. It's a capital intensive business. It's a market-based business with high volatility, it's a heavily regulated business," he said.

The more recent trend has been toward private equity deals or niche start-ups run by experienced management firms. The Carlyle Group is now in exclusive negotiations to buy a majority stake in Sunoco's (SUN.N) Philadelphia plant, the largest on the East Coast and also at risk of closure.

Often in concert with financial investors, big banks have looked to strengthen their trading and risk-management operations with so-called "supply and offtake" deals in which they will contract to supply a refinery with its crude, or sell surplus refined fuels in the open market.

"There are a lot of cash-strapped refineries who need access to cheap capital," said Mark Routt, senior staff consultant with KBC Advanced Technologies in Houston, explaining the trend toward out-sourcing trading operations to a bank.

"The refiner gets a small return and a positive cash flow, while the off-taker has low-risk access to both crude and product markets with no long-term commitment."

JP Morgan, Goldman Sachs (GS.N) and Morgan Stanley (MS.N) have tied into deals with smaller refiners in the United States, including Alon (ALJ.N), Northern Tier and PBF Energy, firms that would otherwise lack the scale to trade efficiently.

The Trainer arrangement has a special allure thanks to its proximity to New York Harbor, offering JP Morgan's oil traders the ability to more closely manage the jet fuel, diesel and gasoline hedges based on the U.S. RBOB gasoline and heating oil futures, which are settled with barrels delivered to the storage tanks in the harbor.

Such supply-and-offtake deals among independent refiners have allowed many such plants to stay open after integrated oil companies started to exit refining, according to an IHS CERA report in February that was commissioned by Morgan Stanley.

Whatever comes, one thing is assured: scrutiny.

"If it doesn't go well, it will get so much more attention than it probably deserves," says Raymond James airlines analyst Savanthi Syth. "But if it goes well, they'll be heroes."

(Additional reporting by Karen Jacobs in Atlanta and Tom Hals in Wilmington; Editing by Leslie Adler)

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